Corporate Valuation

Chapter 7Leverage and Value in Growth Scenarios

In this chapter we introduce the relationship between leverage, opportunity cost of capital, and value assuming a growth scenario.

This assumption will allow us to:

• Point out the hypotheses commonly used by professionals in their discounted cash flow (DCF) valuations¹ and the pitfalls that their model entails;
• Provide useful insights on the estimation of tax benefits.

7.1 GROWTH, LEVERAGE, AND VALUE

As discussed in the previous chapter, we can express the value of a levered company as its unlevered value plus the value of tax benefits (tax shield). In paragraph 6.2, we presented the following equation:

It was based on three crucial assumptions. First, the cash flow from operations was assumed to be perpetual. Second, leverage was not allowed to change over time. Finally, tax shields were discounted at the rate (i.e., their cost was the same as the cost of debt).

Once we allow for growth, this equation needs to be further investigated, even if we are merely adjusting for inflation with a nominal growth rate.

In this situation, cash flow increases over time at a growth rate equal to g. At this point of the analysis, it is irrelevant to specify whether we are adjusting for nominal or real growth. In this newly specified growth scenario, ...